Headwinds Facing Golden State Utilities

Viewpoints

No Rings for this Golden State Team: Challenges to California Utilities

Unlike the Golden State Warriors who have won three out of the last four NBA
championships, the Golden State electric utilities have been struggling to get an
‘assist.’ Due to the recent wildfires in California, issues such as inverse condemnation
have come to the forefront while the other challenges linked to aggressive renewable
energy policies and increasing customer choices without a well thought out plan
have been building over time. The issues described below are of a different nature
compared to the California energy crisis of 2000-2001 but there are some similarities
such as regulation lagging policy objectives and the lack of recognition of external
factors that utilities cannot control. The financial markets are showing a heightened
sense of awareness around California electric utilities and the issues discussed below
bear close watching.

Aggressive Renewable Policies Cause Cost Shifting

Recently, the California Energy Commission voted 5-0 to approve a mandate that
residential buildings up to three stories require rooftop solar installations starting
in 2020. The commission estimates that this would add $40 to monthly customer
mortgage bills but would save $80 on monthly heating, cooling and lighting bills. The
chart below shows California residential solar installations leading other states by a
wide margin, a situation that is reflective of the progressive renewable energy policy
goals in California.

Residential Solar Installed
Capacity Share by State

Source: EIA

California has one of the more aggressive
energy Renewal Portfolio Standards (RPS)
in the country, mandating 33% of retail
electricity sales from renewable sources by
2020 and rising to 50% of retail sales by 2030.
Approximately 30% of 2017 California retail
electricity sales were renewables based, likely
putting California load-serving entities ahead
of schedule for meeting the 2020 RPS target.
While regulators continue to drive a carbon
free agenda, the utilities face a transition
period where they must evolve their business
models while meeting various state policy
objectives. From a supply standpoint, more
fossil fuel power plants will retire because
of environmental rules and challenging economics. As these plants retire, the power grid would be
more dependent upon intermittent renewable resources
(when the sun doesn’t shine or the wind doesn’t blow) which
could then lead to higher volatility in power prices and stress
on the electric grid.

Progress Toward California Renewable Energy Goals

Source: California Energy Commission, December 2017

Rooftop solar highlights the ‘cost shift’ problem. As more
customers install their own rooftop solar panels, the fixed
long–term assets of the utility system (wires and poles)
must still be maintained and paid for. Without proper cost
allocation, customers who do not self-generate power with
solar panels end up bearing more fixed costs of the system
while the customers with solar panels have the optionality of
staying connected to the grid. As rooftop solar penetration
increases this will likely become a bigger problem and utilities
will have to adjust their business model as they cannot
continue to shift the cost burden to non-“solar rooftop”
customers. In a nutshell, fewer customers are left to pay
for the fixed costs of the system, and non-“solar rooftop”
customers contribute more than their fair share of fixed
system costs. The chart below shows the rapid growth in
rooftop solar capacity in California.

Rooftop Solar Capacity in California

Community Choice Aggregation (CCA) in California allows
for cities and towns to join together to purchase electricity for
their residents and provides an alternative to the incumbent
electric utility. The purpose of a CCA is to provide customers
with more renewable energy choices and reduce electricity
costs. They provide electricity to customers while still using
the poles and wires of the incumbent utility (for example
PG&E customers who switch to a CCA will continue using
PG&E’s transmission and distribution lines but will switch to
buying electricity from the CCA). The first CCA was created
in 2010 and there were nine active CCAs in 2017. As more
customers defect to CCAs from utilities, the utilities are left
with some stranded costs on the higher-cost, older electricity
contracts. The stranded costs are then paid for by the
remaining non-CCA customers, a cost burden shift similar to
the one created by rooftop solar. CCA’s are growing at a rapid
pace, but utilities still must act as the provider of last resort.

Percentage of Load Served by CCAs

Source: California Public Utilities Commission, Company Data

Several potential problems exist with the CCA model as we
see it. The electricity demand could be higher than expected
in which case the CCA would need to step in to buy electricity
at market prices, presumably higher. Additionally, if electricity
prices go up then the CCA constituents (cities etc.) could
just switch back to the incumbent utility leaving the CCA
with a stranded cost liability because the CCA may not be
able to charge sufficient exit fees. The flip side would occur
if electricity demand is lower than expected leading to a
scenario where the CCA may have to sell electricity into a
weaker market, causing losses for the CCA. All these scenarios would test the creditworthiness of the CCA, a potential issue
given generally weak CCA capitalization and liquidity compared
to the size of their long–term power purchase obligations.
There also seems to be lack of central planning around how
these customer migrations between electric utilities and CCAs,
and any potential issues would be handled.

Since California utilities will likely be required to act as a
backstop electricity provider if CCAs have issues, any pressure
on the CCAs would be felt by the California utilities and
ultimately may become problematic from a customer and
regulatory standpoint. In essence, the CCAs creditworthiness
hasn’t been tested in a volatile power price environment which
could stress their liquidity and cause solvency issues; if this
unfolds, it would ultimately pressure the California utilities.

Community Choice Aggregators
Asset/Liability Mismatch ($ Million)

Source: Company Reports

Recent Wildfires & Inverse Condemnation

Inverse condemnation presents yet another unique, if not
the most acute risk for California utilities. Under the state’s
constitution, a utility has strict liability for claims related to
events such as wildfires if its equipment is found to be a
contributing cause of fire under the assumption that these
costs can be socialized. However, the recovery of these costs
from ratepayers may not be allowed by regulators even if the
utility wasn’t at fault.

Wildfire related damage and claims effectively create a liability,
which the utility may not be able to recover from ratepayers,
and therefore the utility’s investors then act as the backstop.
Wildfires have become increasingly common in California
over the past few years. Recently Southern California Edison
obtained $300 million of wildfire insurance for 2018 at an
annual premium of $121 million, highlighting the very high risk premium associated in underwriting California wildfires.
The below charts show that a majority of the wildfire related
destruction in California has happened over the past five
years, and the increasingly warmer temperatures coupled with
reduced precipitation may be playing a role in causing the
wildfires. We have seen increasing instances of above average
temperatures in California over the past couple of decades
which implies that the wildfire related risk may be here to stay
for California utilities.

Rising Wildfire Destruction

Source: California Department of Forestry & Fire Protection

California Annual Mean
Temperatures vs. 100 Year Average

Source: Western Regional Climate Center

In most other states utility regulators provide extraordinary recovery
mechanisms to utilities (passing through costs to customers)
when they face extreme weather events like storms and
fires. This may not be the case for California, which is a cause for
concern for California utility investors. In October 2017 alone, 21
wildfires in Northern California (Pacific Gas & Electric territory) burned 245,000 acres, destroyed an estimated 8,900 structures
and caused 44 fatalities. The December 2017 Thomas fire burned
280,000 acres, destroyed 1,063 structures, damaged 280 structures
and caused two fatalities in Edison International’s (EIX)
territory. It is unclear if the utility will be able to recover from its
ratepayers any wildfire-damage-related claims that it has to pay
out. As a result, PG&E and EIX stock have declined significantly
(loss of ~$11B and $3.5B respectively in market capitalization
and shares down 33% and 14%, respectively, over the past year).

Performance of California
Utilities Equities vs. Utilities Index

Source: California Department of Forestry & Fire Protection

Policy objectives in California are currently focused on
renewables and customer choice while potential cost-shift
issues do not appear to be a high priority, creating risk for
electric utility customers in California. If electricity prices
go up, it may cause turmoil in the CCA market, which may
ultimately impact the customers and the utilities. As rooftop
solar continues to grow in California, the cost-shift problem
likely grows with it. Lastly, if a utility cannot recover costs
related to natural disasters the entire business model is put at
risk. While the issue of wildfires and the associated liabilities
has clearly weighed on investor minds, TCW’s view is that
CCAs could present a significant challenge as well. Electric
utilities are responsible for safe and reliable grid operations,
and irrespective of fault they will be dealing with any issues
stemming from lack of well thought out policies and planning.

The question is whether California’s lawmakers and utility
regulators consider these as serious enough issues, and if
they will proactively address them through balanced policies
and regulation? While we see a long–term sunny future for
utilities in the Golden State, there are some clouds on the
horizon, and it would be up to the California lawmakers
and regulators to provide an ‘assist’ in the form of balanced
policies and regulation of the electric utilities in the state.
In the long–term, this assist would likely be the best path
forward for the customers and utilities alike.